Monday, 23 March 2015

Impacts of Grexit

Many
analysts and commentators have been discussing the potential of a Greek exit
from the Eurozone, or “Grexit”. This is a very complex subject which cannot
easily be assessed without a detailed econometric assessment of Greece’s
economy and a wider assessment of Greece’s polity and society. What is possible
is to explore some major themes and issues of a Grexit, and examine some
relative impacts these may have on Greece’s economy and society. As there are a
large number of variables involved, what follows is more of a concept note than
a specific forecast.

This article was originally written on 12 February 2015 and first appeared on the Navigator website.

Issue 1: Grexit within the Euro

Contrary to
popular understanding, a “Grexit” does not necessarily mean a new currency will
be introduced. The key monetary requirements for participation in the Euro are
in fact contained in the Maastricht criteria of the Maastricht Treaty. It should be clear
from an examination of these criteria that Greece has been in violation of the
Treaty since it joined the Euro, yet it has continued to use the Euro currency.

One
definite alternative is that Greece will unilaterally default but remain within
the Eurozone. What does this mean?

·Greek banks and the Greek government
would be barred from using European Central Bank refinancing in all but the
narrowest of transactions (this is now already the case).

·Other Eurozone countries no longer
accept Target 2 transfers, or specifically, liabilities, involving Greek
transactions. There is no precedent for this, and it is uncertain how this
would work in practice.

·Any other Eurozone public sector
financing of Greece stops. This might include a cancellation of disbursements
of European structural and cohesion funds.

·Greece’s credit rating would of
course fall to unprecedented lows, and any form of foreign investment or
lending would be eliminated.

In this
case, the practical impact for Greece businesses and citizens will be that:

·The Greek banking system will
effectively have to be either nationalised, liquidated and merged, depending on
the severity of the problem. The Greek state currently controls the majority of
shares in three of the four systemic banks and would be within its rights to
take drastic action.

·The Greek government will begin
honouring its commitments (salaries, pensions, etc) using a mix of cash and
promissory notes or Greek government bonds.

·A barter economy will quickly grow,
replacing cash transactions.

·A black market for cash leaving or
entering the country will quickly emerge.

·Official economic activity will fall
dramatically.

Many
economists will no doubt respond that this idea is preposterous: that the idea
of Grexit is to leave the Eurozone, develop a new central bank and currency,
and allow that currency to devalue as a means of regaining competitiveness and
control of the economy.

But this is
not so simple, and any move in this direction will almost certainly include
some of the preliminary stages discussed previously. Why?

·Because the majority of the Greek
population does not want to leave the Euro. Doing so carries an important
political risk for the ruling party that proposes such a move.

·Because even if Greece has a new
currency, as long as it is in the European Union it is bound by the “Four Freedoms”, or free movement of people,
goods, capital, and services. As long as this is the case, Greece cannot
unilaterally levy the tariff and credit barriers which are a necessary
complement for a currency devaluation to function. It will still be part of a
common trade area in the EU (and by extension China and other non-EU
countries), and will still have grievous competitive disadvantages in the real
economy.

·Because even a Grexit does not mean
that the national debt is eliminated (see next section, below).

Issue 2: Grexit outside the Euro

Grexit, as
usually implied in the press, necessitates Greece developing a new currency
(the “NewDrachma”), managed by the Greek Central Bank. Many analysts, including
Paul Krugman, imply that Grexit is manageable,
and that the current costs of the Greek bail-out are equivalent to the economic
damage expected from Grexit anyway.

But this
scenario is also flawed. It ignores—or assumes—that simply by exiting the Euro,
Greece’s public debt will disappear. It will not.

Nearly 80%
of Greece’s € 322 billion public debt is in the hands of official creditors.
There is no reason to assume that:

a.This debt will be forgiven following
Grexit, and/or

b.This debt will automatically be
re-denominated in New Drachmae.

It is
sloppy intellectual reasoning to imply that either of these two conditions will
materialise as a fait accompli of a Grexit.

The damage
of Grexit under the current circumstances is the worse of all worlds. It would
require a rapid deflation of the New Drachma against other hard currencies,
while making the public debt impossible to service. In fact, this scenario is
exactly what happened to Germany in 1919 at the end of World War II, when it
was forced to pay reparations in gold or foreign currencies.

The result
of Germany’s experience is in the historical record: hyperinflation, poverty,
and the rise of extremism which lead to Adolph Hitler’s takeover of the
Reichstag through a mix of legal and extra-legal means.

As a
result, a classical economics analysis of Grexit would assume the following:

a.Immediate devaluation of the New
Drachma by 40-60% against the Euro and US Dollar. Greek GDP would automatically
fall by the same percentage in hard currency terms, creating a renewed cycle of
uncertainty.

b.All important trade and other
contracts would remain formally or informally pegged to the Euro or US Dollar
Libor or Eurobor rate, creating an incredible pressure on the New Drachma. This
has been seen in Russia following the 1998 devaluation, and even in Greece
prior to Euro entry.

c.Imported products, including most
consumer goods, automobiles, oil and gas, and many foodstuffs and stables,
would automatically become 40-60% more expensive.

d.Inflation will begin rising to
15-18% per year in the best case scenario in the 2-3 years following the new
currency.

e.Greek exports and service exports
(tourism) would become more competitive. However, they would be deprived of
working capital necessary to finance imports, exports, or the 3-6 month credit term
demanded by most tour operators for Greek hotel rooms. As a result, Greek
enterprises will not be able to take advantage of the declining currency, at
least not in the short term.

f.Greek services and products sold in
the domestic market would become more competitive, assuming that the large
majority of their inputs are sourced in Greece. For instance, Greek potato
chips made from Greek potatoes would be more price competitive that Greek
potato chips made from Polish potatoes (depending on the cost of energy,
transport and packaging).

g.Inflation and uncertainty will lead
to an immediate fall in consumer spending and investment, at least over the
short term.

h.Greek banks would likely be forced
to convert their Euro-denominated loans to New-Drachma-denominated loans, at
the starting price of the New Drachma. As the New Drachma devalues, however,
the headline cost of the loan would increase either in or out of proportion
with the devaluation and/or inflation. So either the banks will go bankrupt
through loan write-downs (and borrowers will benefit), or borrowers will be strangled
by an ever-appreciating cost of their loan. Whatever the case, new credit
issues from Greek financial institutions will be eliminated.

i.Strict credit and transfer limits
will be introduced. Cash withdrawals from banks will be limited. International
outbound transfers will be limited. Incoming transfers or cash exchanges will
be automatically converted at the low, “official” rate. There will be a growing
gap between the official and unofficial exchange rates for the New Drachma.

j.A lucky few and the
politically-favoured will enjoy access to scarce credit. Everyone else,
including healthy enterprises and families, will suffer. We have seen this
scenario before in Greece, notably with who got loans from “private” banks or
state-backed banks such as ETBA.

k.It must be emphasised that even with
a devalued New Drachma, Greece remains part of the Eurozone. As a result, we
can expect fire sale prices of vacation homes, agricultural land, companies and
all kinds of other assets, as European investors descend on Greece eager to
take advantage of their strong currency, and as Greek owners desperately sell
at any price. Much of the transactions will be done offshore or “under the
table”, enabling the Greek seller to avoid tax and keep hard currency income.

It is
difficult to forecast how long the adjustment shock would last, but I believe that
2-4 years will be necessary before the economy begins to grow and function
again at anything approaching a normal trend rate.

In time,
assuming stable political developments, one could imagine Greece returning to
the economic system it enjoyed in the late 1980s: a continually-devaluing
national currency; high inflation; very limited credit; rampant demagoguery and
corruption in the political class. The last point has arguable not changed much
since then.

But now we
need to ask what happens not from a classical economics viewpoint, but from the
social and political viewpoint. This is perhaps best done by posing a series of
questions that are rarely heard.

a.Why should we assume that Greece
will remain stable?

b.How long will Greece remain a
democracy given the relatively calm scenario discussed above? How long will it
remain a democracy given the presence of political parties which have relied
upon extra-legal tactics in the past?

c.Who will be the next “man on a
horse” (one of many in Greek history) to “save Greece?”

d.Can Greece survive in the European
Union even if it exits the Eurozone? Can it survive a devalued currency given
its free market agreement and inability to set protective tariffs?

e.Will other European partners
tolerate continued Greek involvement in European decision-making and support
programmes given the magnitude of the implied default? Or will other European
societies turn against Greece, and against the Greek diaspora communities
living in their midst?

f.Can Greece continue to defend its
national borders against an irredentist neighbour when it will be unable to buy
fuel, spare parts or ordnance for its military, or when its European partners
will be manifestly unwilling to get involved in any further Greek adventures?

g.Viewing the constant scenes of
poverty and tension in Greece, what happens to foreign tourism arrivals in the
immediate aftermath of a devaluation? Do we really assume that tourism and
normal economic flows will remain unaffected?

h.What will popular reaction be when
the population views “locust investors” asset-stripping Greece at low prices,
or hears yet more tales of starving schoolchildren?

As stated
previously:

·There is no point in Grexit without
a simultaneous exit from the European Union, allowing Greece to fully set its
own tariff and credit policies.

·Given Greece’s failure to manage its
economy and public sector properly over 30 years of prosperity, we should be
under no illusions that it will do any better in the economic depression and
crisis that would follow a Grexit.

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